What Happened On Wall Street and Why

Ever since the mid-1980s, untold millions of Americans have increasingly come to view the stock market as being something akin to a comfortable chair, instead of the risky, unstable, unpredictable, incomprehensible, and downright dangerous place that it so clearly is.

Even the top financial minds on our planet, including those at the US Treasury, can’t seem to figure out the value of securities held on corporate balance sheets, but somehow you can? And, even though something like 80% of professional investment fund managers can’t beat the returns of the S&P 500 Index each year, somehow you will?

The realities of investing in the stock market could not have been made clearer over the past couple of months: it’s a very risky proposition, simple as that. And if Wall St.’s recent meltdown hasn’t changed the way you view investing for your retirement, then frankly you deserve whatever you get. The causes of our latest market meltdown, however, could not have been made murkier for the average American.

Some would have us believe that its “sub-prime borrowers” that caused our economy to go south. Others place the blame on the aggressive and greedy nature of our financial institutions. And still others are pointing the finger at our government’s lack of oversight. So before we examine whatever lessons there are to be learned, let’s clear things up a bit as related to what’s happened and why. Because the truth of the matter is, no single thing caused our financial markets to meltdown; no single thing has that much power. It truly is a case of “the perfect storm”.

How it all got started…

1.The Last Bubble – You remember the last market bubble that popped. The sound echoed from Silicon Valley to Wall Street, and we had one heck of a time getting the gum out of our collective hair. The “dot-com meltdown,” which began in 2000, cost Americans trillions, and threatened to send our economy into a very serious recession. We promised ourselves never to make such risky bets again. From now on we’d stick to things we understood… things of real value that would be safe… like real estate, for example.

2.Cheap Money – Lucky for us, our Federal Reserve was right there to support our newfound investment prudence, reducing interest rates to historic lows (essentially to zero if you factor in inflation), and off we went to assume our rightful positions as Real Estate Tycoons. Our dot-com inspired desire for the perceived relative safety of real estate, which was being fueled by the incredibly low interest rates, combined with an anemic stock market to create an enormous amount of available capital for mortgages. Too much capital, perhaps.

3.Too Much of a Good Thing – The abundant supply of money for mortgages was merging with a seemingly insatiable demand for real estate and creating a new bubble. With lenders now in fierce competition to make loans, credit standards were lowered and the number of so-called “sub-prime” loans increased. (It’s worth noting that “sub-prime” loans have always existed, they were just made at higher interest rates to compensate investors for the increased risk.)

Okay, so far? Good. Now it starts to get a little trickier:

4.The Secondary Mortgage Market – Most homeowners have come to understand that banks and other lenders who originate home loans, don’t keep them on their books… they package them up in bundles ultimately sold as “Mortgage Backed Securities” and “Collateralized Debt Obligations” to more long-term investors, such as mutual funds, insurance companies and pension plans. It’s referred to as the “secondary mortgage market”. By selling these packaged securities, lenders free up capital so they can go out and make more loans. The liquidity provided by this secondary market is a crucial component to our economy because without it, lenders would quickly run out of money to lend, as they waited decades for their available capital to be replenished as a result of mortgages being paid-in-full.

5.The Credit Rating Agencies – No, not the ones you’re thinking of, but the far less familiar ones that rate various securities and bonds, such as Moody’s, Standard & Poor’s, and Fitch. These agencies place ratings on various securities, such as the Mortgage Backed Securities and Collateralized Debt Obligations that were now being sold on the secondary mortgage market. Ratings are very important because they allow investors to make decisions about values and relative risks. For example, Standard & Poor’s highest rating, “AAA” means lower risk, and a rating of “D” means the risk couldn’t be higher. Investors expect high ratings to mean relatively low risk… and lower potential returns. And they expect low ratings to mean higher risk, with the potential for higher returns.

Enter: The Federal Reserve…

6.Fears of Inflation – The Federal Reserve’s Board of Governors vacillates between two key fears: recession and inflation. Ever since our economic recovery of the 1980s, the Fed has managed to keep our recessions relatively mild by controlling the nation’s money supply through its setting of short- and long-term interest rates, among other things. When it comes to the ability to control inflation, however, the Fed’s governors are far less confident. Inflation is a spiraling force whose momentum, as seen throughout the 1970s, has been proven difficult to contain. And by 2004, with everyone now congratulating themselves on their real estate investing prowess, people were spending freely and that was spooking the Fed’s governors.

7.Oil Prices Rise – Forget about how much we pay for gasoline at the pump, the bigger problem with oil prices is that rising oil prices mean higher everything prices. Not only is oil what fuels the transportation of goods, but it’s also used to make just about everything we use on a daily basis, from plastic bags to roofing tiles. With the Fed already nervous about consumer spending, as a result of our real estate wealth pushing inflation higher, now the price of oil looked like it would add fuel to the already burning inflationary fire.

8.Fed Fears Inflation More Than Recession – By 2005, the Federal Reserve was much more afraid of inflation than of recession. By July of 2006, they had already raised interest rates 17 times in a row! They had seen the need to slow the economy down a bit in order to reign in inflation, and they were working hard to do just that.

9.The Incredibly Adjustable Mortgage – During the real estate market’s boom times, as lenders were fiercely competing to make loans, they came up with all kinds of “teaser rates” and other loan features that provided people with lower monthly mortgage payments than would have been the case in fixed rate mortgages, and with real estate prices steadily rising, many borrowers took the deals. If interest rates were to rise, the thinking went, one would simply refinance their loan at a fixed rate.

10.They Did, But You Can’t – So, as the Fed continued to raise rates to control inflation, the new-fangled adjustable rate mortgages adjusted right along with them, which meant that lots of monthly mortgage payments, unless refinanced, would soon be going up. And, of course, those with the lowest incomes, who bought at the market’s peak, who have the least amount of equity, would suffer from the higher monthly mortgage payments first. Better refinance soon. But the higher rates were working to slow down the economy. Real estate prices started to level off and then decline, making it more difficult to sell or refinance a home.

11.Credit Ratings & Real Value – The problem started to snowball when some of the Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO) which had been rated “AAA” by Standard & Poor’s and purchased by large institutional investors on the secondary mortgage market, started to see some loans defaulting. You see, inside those MBS and CDO securities were a lot of “AAA” assets, but apparently there were some sub-prime loans and other complex financial instruments referred to as “derivatives” that should never have been rated “AAA”. Some of the investors holding these assets, such as pension plans and mutual funds, operate under by-laws that prohibit them from holding anything but “AAA” rated securities, so when the credibility of “AAA” ratings came into question, the investors had no choice but to sell them in a hurry, oftentimes at deep discounts.

12.The Problems With Rating Complex Securities – Some securities are easy to value and rate as to their credit worthiness. For example, bonds issued by corporations or municipalities both have markets and can be readily sold, so their value is fairly easy to ascertain. Other assets, especially those that don’t have markets through which they can be readily sold, are much more difficult to value. Your daughter’s old collection of Beanie Babies is an example. As long as there was a market of buyers for Beanie Babies they were “worth” whatever the market was willing to pay, but without that market of buyers, your furry little friends are only worth something to you. As the rising interest rates continued to push monthly mortgage payments higher, the secondary mortgage market of MBS and CDO securities dried up, as investors, now unable to trust the ratings, were also unable to establish the value and associated level of risk of these complex securities.

13.No Secondary Market Means Credit Tightens Fast – Without investors to purchase MBS and CDO securities, the secondary market for mortgages started to freeze up. Banks and other lenders, now in an environment far less liquid, immediately tightened their credit requirements for home loans. Now, homeowners with less than perfect credit, who would have been approved for a mortgage six months earlier, found themselves unable to refinance their home loans that were continuing to adjust up with the rising interest rates set by the Fed… to control inflation, remember? And, as credit tightened, fewer and fewer people could buy homes… and with less people now able to buy homes, the prices of homes started to fall.

14.The Downward Cycle Gains Momentum – As monthly mortgage payments continued to adjust up, as a result of the higher interest rates, more and more people found themselves between the proverbial rock and hard place. Their monthly mortgage payments were increasing beyond their ability to pay, but they couldn’t refinance. And now, with real estate prices dropping faster and faster, they couldn’t sell their homes either. Trapped. Foreclosures started to rise, which only caused further harm to the secondary mortgage market, which in turn led to tighter credit requirements, which in turn reduced the number of home buyers, which in turn brought home prices further down, which in turn made it harder to refinance or sell a home. The dominoes had started to fall.

One more ingredient and the perfect storm…

15.FAS 157 & 159 – Then, late in 2006, one more factor came into play and it created nothing short of the perfect storm. FASB is an acronym that stands for “Federal Accounting Standards Board,” and they are the group that sets the standards for the accounting practices of public companies. Partly in response to the dot-com collapse and partly as a result of ENRON’s bankruptcy, FASB had adopted two new accounting rules, FAS 157 & 159. These new regulations, referred to as the “mark-to-market” rules, require public companies to mark their assets down each quarter to the price that they would receive were they to sell them at that moment. It doesn’t matter what the company paid for the asset, or take into account whether the asset is performing or not. In other words, even if a company owned “AAA” rated mortgages that were all paying on time each month as agreed, since the value of real estate had declined and the secondary market for such securities had dried up, the value of that block of loans would still have to be “written down” on the company’s balance sheet.

16.The “Shorts” and the Cycle Continues – Throughout 2006, 2007, and into 2008, companies were being forced to write down these hard-to-value assets to the tune of tens of billions of dollars each quarter. Each time a company would announce another write down, the “shorts,” who are investors that seek to make profits from the decline in a company’s stock price, would start aggressively shorting that company’s stock. Now, the credit rating agencies, when rating public companies, take into account not only a company’s financial position, but also the number of short positions. The thinking is that if many investors are shorting the stock, meaning that they are betting that it will go down in the future, there must be a reason… and that company’s credit rating may be in jeopardy. For a company like AIG, or Merrill Lynch, or Lehman, or Morgan, or Goldman, or many others, if their credit rating drops, the amounts they have to pay to service their debts goes up… and in some cases, by billions of dollars. It’s just like a consumer with less-than-perfect credit being required to pay higher rates than one with a perfect credit score.

17.Like a Fire Burning Out of Control – More write downs led to more short sellers, which put more downward pressure on each company’s stock price, which threatened its credit rating and made it more difficult to raise the cash needed to balance its books as a result of the write down. And with no market for the hard to value MBS and CDO securities, they would continue to fuel further write downs, and so on… and so on. Meanwhile, the lack of a secondary market for mortgages continued to reduce the availability of credit for more and more Americans, which created more defaults and foreclosures, which led to even lower home values, and so on… and so on.

18.Too Little, Too Late – Of course, by 2007 the Fed had become less fearful about inflation and more concerned about recession, lowering rates seven times during that year. But it was too late. The lower rates were meaningless in an environment in which few people could qualify for loans and housing prices were dropping. And clearly, our politicians were either in denial or asleep at the wheel. By the time they realized what was about to happen, it was well into the eleventh hour. Now our government saw that they would have to “bail out” companies like Bear Stearns, Freddie & Fannie, AIG, and countless others who would be in line behind them.

19.Lehman Bros. – For whatever reason, Treasury Secretary Paulson chose to let Lehman Bros. go under. Why? I don’t think anyone really knows, and most in-the-know believe that Paulson regrets this decision. Paulson says he had no choice as Lehman had no collateral, as did AIG. But the impact is undeniable. Allowing Lehman to default almost immediately froze the credit markets, placed AIG’s financial stability in jeopardy, and made a bad situation that much worse.

20.So Here We Are – It’s hard to imagine, but on September 15th, the Fed’s Chairman and Treasury Secretary had to get in their cars, literally run up to Capitol Hill, and explain to our clearly shocked leaders that our house was on fire and they would need to pass a bill creating the largest federal expenditure in history… in a week… or ALL would be lost. Now that’s cracker jack planning, don’t you think? Who should be more embarrassed? The guys at AIG or Lehman, or those playing politics on Capitol Hill or running the Federal Reserve and Treasury Department? You’ve got to admit, it’s a tough call.

21.Not the End, By Any Means – So, there you have it. A truly perfect storm. Lots of capital looking for the perceived relative safety of real estate, low interest rates, competition that created “teaser rate and zero down payment loans” made available to those with less-than-perfect credit (and worse), inflationary fears and rising oil prices, higher interest rates, unreliable ratings of complex securities, new accounting standards, leverage, short sellers, politicians and policy makers without a clue… and now an American public looking for some individual on which to heap the blame.

Will things get better? Of course they will, but it could take quite some time before they do. Like a decade, isn’t out of the question. And our government’s response thus far, hasn’t been particularly helpful… to say the very least.

The government doesn’t have to mark its assets down to market value each quarter as public companies are required to do by FAS 157 or 159, so it planned to take over billions of dollars in mortgage related securities, hoping that the outcome would be lenders lending once again.

This was Paulson’s original intended use for the $700 billion TARP funds. He changed his mind, however, when he realized that this approach would take a significant amount of time, time he felt he didn’t have. The banks were willing to play chicken, demanding 100¢ on the dollar, and there was no way to determine what the assets were really worth. So, he changed his mind mid-stream, deciding that the better course was to inject cash into financial institutions through the government’s purchase of equity in the form of preferred stock, which is more like debt than equity.

The outcome of the TARP thus far has been questionable at best. Lending has not even flirted with returning to “normal,” whatever “normal” should be. The banks that have received TARP funds have declined to disclose how they’ve used such funds, and now they’ve started paying these funds back in order to avoid having to comply with those bothersome restrictions on executive compensation. The banks are keeping the trillions in FDIC guaranteed loans, however, as they don’t have such restrictions on compensation.

Many waited for President-elect Obama’s plans, as if they might have contained some sort of magic bullet solution. Alas, there is no magic bullet to be had. While there may not be a single bad guy or group of bad guys to blame for our troubles, it is the banking lobby’s interests that are no longer aligned with ours, and our politicians must hear that we demand that they stand up for the people, not just the banks.

Part of the problem we face in finding solutions to our economic issues is that defining our credit crisis as a sub-prime borrower problem conjures up images of a mysterious, irresponsible underclass, screwing up while all the conscientious people suffer as a consequence of their mistakes. Who would want to help this irresponsible group who so clearly have brought this on themselves? And, if we, as a nation, can’t come to terms with the numerous factors that have caused our economy’s problems, what chance do we have of fixing them?

The reality is, we (and when I say “we,” I suppose I mean our elected officials) have let the dominoes fall, and fall too far in the wrong direction. Now we need to look at ways of stopping those dominoes from continuing to fall unchecked, because allowing them to do so is clearly hurting all of us.

In order for our economy to begin down the long road to recovery, our housing market will have to stabilize, and that means that the current wave of foreclosures will have to stop. Some experts, including perhaps most notably FDIC Chair, Sheila Bair, have advocated loan modification programs, but the implementation has fallen far short of effectiveness. Others say that only the free market can fix what’s gone so very wrong, which although true in the long run, would be too painful for the tastes of our politicians.

So, at this point, one way or the other, we the taxpayers will have to buy the toxic assets that still exist on bank balance sheets before lending will come back at all. If we buy them at asking price, we’ll lose hundreds of billions. But if we buy them at a discount, we’ll leave holes in the bank balance sheets and have to give them hundreds of billions to fill those holes. Do you see what I’m saying? We the taxpayers are going to pay this bill one way or the other. The banks bankrupted themselves and we’re going to pick up the tab no matter what.

The question is… how toxic will we let the assets in question get? And that’s a question of stabilizing the housing market. The lower it goes, the more we will all pay. So, programs that stop the foreclosure crisis aren’t really about paying for your neighbor’s kitchen remodel. And Rick Santelli of CNBC is an idiot for saying so.

Make no mistake about it, however, it’s not simply a “failure of the free market” that brought us here. If it were, then we wouldn’t have needed to pass a $700 billion “rescue bill” and provide the banks with untold trillions in FDIC guaranteed loans. It takes a lot to bring Wall St. to its knees… a lot to cause a global financial crisis… a lot more than any of the over-simplified explanations that attempt to place the blame on any one thing.

Regardless of what we do, looking ahead it will be much harder to get a loan than it used to be, no question about that. With the dollar’s value sure to be kept low, the hope is that foreign capital will continue to pour in to the government’s coffers, but with the debt being what it is, that’s far from a certainty.

But until homeowners are able to refinance their adjustable and recasting mortgages into affordable loans, and foreclosures abate as a result, we’ll see no recovery. As they say, this too will pass… but not tomorrow, not next year, and not for a long time, unless we do more to push back against the interests of the banks, and stabilize our housing markets… and in that regard, we’re running out of time.

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